The new landscape of the infrastructure debt market

Opportunities for banks and institutional investors

Belgian infrastructure debt market has undergone considerable changes in the past years. Due to low interest rates environment together with new banking and insurance regulations, market players have revised their infrastructure investment strategies. In order to investigate the recent developments in Belgian infrastructure debt market and their origins, professor Issam Hallak and researcher Mathias Wambeke conducted interviews with market players, representative of the different categories: lenders (banks and institutional investors), private equity funds, public entities, financial advisors, and regulators.

The survey confirms that banks have been withdrawing from infrastructure debt financing. The main factor for such trend that is put forward is the new liquidity requirements included in Basel III. Also, assets with longest maturities such as infrastructure loans have become excessively costly for banks. In fact, on top of smaller volumes, our numbers show shorter average maturities on infrastructure debts. Such maturities are yet unsustainable for project financing which needs long maturities.

Instead, institutional investors, such as insurers and pension funds, show growing interest in the infrastructure debt market. The long term and illiquid nature of infrastructure loans provide a good match for their long term and illiquid liabilities. Moreover, because of the current low interest rate environment, institutional investors are constrained to seek investment alternatives to traditional low risk government bond investments. Clearly, the main alternative are public-private partnerships (PPP) which provide loans with low risk but more attractive yields.

Nevertheless new entrants to the infrastructure debt market are faced with major challenges.

The main challenge is the lack of credit risk valuation expertise of complex infrastructure projects.

Last, institutional investors lack networks of stakeholders in the infrastructure market with whom they maintain a “customer relationship” the way banks do.

From the interviews, Issam Hallak and Mathias Wambeke report a number of consequences from the previously described trends.

1/ First, banks and institutional investors are building new valuable partnerships in infrastructure finance. Banks can leverage their risk appetite and lending experience by originating infrastructure loans and financing the construction phase. In a second stage, institutional investors buy the receivables of the infrastructure loan from the bank, or provide a long term loan to the project’s special purpose vehicle. By doing so, institutional investors benefit from a long-term, low risk, illiquid investment. Banks and institutional investors have turned challenges into opportunities.

2/ The contract developed above is complemented by the emergence of infrastructure debt funds. Such funds are particularly attractive for smaller institutional investors who have insufficient funds to invest and diversify across infrastructure loans. Besides, infrastructure projects are typically complex and of significant size, thus requiring thorough due diligences. Infrastructure funds overcome these hurdles by pooling several investors’ funds within a single investment fund, screen projects and diversify. Even though infrastructure debt funds have hardly been successful so far, they may be a solution for relatively small institutional investors and will probably become more widespread over the next years.

3/ The use of bonds for infrastructure projects is another innovation in the infrastructure market. Infrastructure related bonds provide additional liquidity to creditors and are more transparent due to their credit rating. Nevertheless, bonds bear substantial problems. Among others, pricing of bonds are usually only determined upon issuance, hence a pricing risk will inevitably remain during the procurement process. Also, bonds are far less flexible than bank loans, and financial flexibility is essential especially in the construction period. For instance, revolving credits are very common in infrastructure financing, but impossible with bonds. Last, issuing costs of public bond are relatively large and thus may be limited to large infrastructure projects only, likely above €100 million.

In order to support growing demand for infrastructure investments from new entrants, the European Investment Bank (EIB) has set up the Project Bond Credit Enhancement (PBCE) programme. Within the PBCE, the EIB either provides a subordinated loan to the project’s company for half of the project cost, or provides a guarantee if the cash flows generated by the project are not sufficient to ensure debt service. Such a mechanism effectively enhances the credit rating of the senior debt, which in turn attracts institutional investors to the infrastructure market.

The Spanish “Castor Underground Gas Storage” refinancing is the first and a representative case of a bond issuance combined with EIB support. The project financing includes a twenty-year bond and EIB subordinated liquidity facility. The final user of the project is the Spanish government which provide stable and predictable payments. As a result, the bond received an investment grade rating. The combination of long term, stable cash-flows, and low risk investment successfully attracted institutional investors who purchased 61% of the bond value (only 3.9% were bought by banks). Nevertheless such solution is hardly generalizable to all types of infrastructure projects.